Monetarism and the Chicago School

Introduction

Monetarism and the Chicago School represent two fundamental pillars in the history of economic thought that emerged in the mid-20th century. Monetarism, with its emphasis on controlling money supply to stabilize the economy, and the Chicago School, known for its broader laissez-faire approach to economics. Both had a profound impact on economic policy and theory during the latter half of the 20th century.

These economic schools are strongly associated with the works of Milton Friedman, who helped shape modern views on monetary policy, inflation, and the role of government intervention in markets.

Monetarism, specifically, can be understood as a reaction to Keynesian economics, which dominated the mid-20th century, and its focus on fiscal policy and government intervention. The Chicago School, while also advocating for limited government intervention, broadened the application of market-oriented thinking to all areas of economics, including microeconomics, macroeconomics, and even law and political theory.

Historical context: the decline of Keynesianism

To understand the rise of Monetarism and the Chicago School, it is important to consider the historical context in which these ideas emerged. After World War II, Keynesian economics dominated the Western world. Key tenets of Keynesianism, such as active fiscal policy, government intervention, and the notion that demand management could smooth out business cycles, became the cornerstone of economic policy, particularly in the U.S. and Europe.

However, by the 1970s, several problems began to arise, most notably the phenomenon of stagflation, or simultaneous inflation and high unemployment, which Keynesian models struggled to address. The failure of Keynesian economics to effectively handle stagflation created an intellectual vacuum that Monetarism and the Chicago School would soon fill.

As inflation surged, especially in the U.S. during the 1970s, critics of Keynesianism, such as Milton Friedman, began to advocate for a shift towards a more market-oriented approach that focused on monetary policy rather than fiscal intervention.

The key tenets of monetarism

Monetarism, as articulated by Milton Friedman, places primary importance on the control of the money supply as the most effective tool for managing the economy. Monetarists argue that fluctuations in the money supply have direct and predictable effects on inflation, output, and employment.

The central premise of Monetarism is that inflation is always and everywhere a monetary phenomenon, meaning that long-term inflation is caused by excessive growth in the money supply, rather than external factors like wage demands or supply shocks.

Monetarists reject the Keynesian emphasis on fiscal policy and demand management, asserting that such interventions lead to distortions in the economy and cause more harm than good in the long run. Instead, they advocate for a fixed annual increase in the money supply, in line with the natural growth rate of the economy, to maintain price stability and foster steady economic growth.

One of the most influential aspects of Monetarism is its focus on the natural rate of unemployment, which is the rate at which inflation is stable. According to Monetarists, attempts by the government to reduce unemployment below this natural rate would lead to rising inflation without reducing long-term unemployment.

As a result, Monetarism challenges the Keynesian idea of a trade-off between inflation and unemployment (the Phillips Curve), arguing instead that such a trade-off does not exist in the long run.

Milton Friedman and the rise of monetarism

Milton Friedman is the central figure in the development of Monetarism. His work in the 1950s and 1960s, particularly his influential book A Monetary History of the United States (1963, co-authored with Anna Schwartz), challenged the Keynesian consensus of the time. In this work, Friedman demonstrated that changes in the money supply were closely correlated with fluctuations in output and prices. He provided empirical support for the Monetarist view that monetary policy, rather than fiscal policy, should be the primary tool for managing the economy.

Friedman also criticized the Keynesian view of active government intervention, arguing that the role of the government should be limited to maintaining a stable monetary environment. His views were further developed in his 1968 presidential address to the American Economic Association. He outlined the core principles of Monetarism, including the idea that inflation is a result of excessive money supply growth and that monetary policy should be guided by fixed rules rather than discretionary decision-making.

Friedman’s advocacy for Monetarism gained significant traction during the 1970s, as central banks around the world, especially the U.S. Federal Reserve, began to struggle with inflation. His ideas were particularly influential in shaping U.S. economic policy under President Ronald Reagan and British policy under Prime Minister Margaret Thatcher in the 1980s. Monetarism became the guiding principle behind efforts to curb inflation and reduce the role of the state in economic affairs.

The Chicago School of economics: the broader ideological framework

While Monetarism is a specific school of thought that focuses on the role of money supply in economic management, the Chicago School represents a broader intellectual tradition that emphasizes free-market principles, limited government intervention, and the importance of individual choice.

Founded in the 1940s under the leadership of economists like Frank Knight, Jacob Viner, and later Milton Friedman, the Chicago School was a direct response to the rise of Keynesianism and the increasing role of government in economic affairs during the mid-20th century. Chicago School economists reject the idea that government intervention can improve market outcomes and argue instead that markets, when left to operate freely, are self-correcting and efficient.

Central to the Chicago School is the belief in the superiority of markets in allocating resources and setting prices. Chicago economists, like George Stigler and Gary Becker, extended these ideas beyond traditional economic spheres, applying market principles to areas such as law, education, and family dynamics.

One of the key contributions of the Chicago School to economic thought is its emphasis on the role of information in markets. Economists such as Stigler argued that markets work best when information is freely available and when individuals are able to make decisions based on their own preferences and needs.

The impact of Monetarism and the Chicago School on economic policy

The practical implications of Monetarism and the Chicago School’s free-market principles were realized most dramatically in the 1980s, when their ideas began to shape the economic policies of major Western governments. In the U.S., President Ronald Reagan’s administration embraced Monetarist ideas, particularly the need to control inflation through strict monetary policies.

The Federal Reserve, under Chairman Paul Volcker, implemented tight monetary policies that led to high interest rates and a significant reduction in inflation. At the same time, Reagan’s economic policies reflected Chicago School principles, including tax cuts, deregulation, and a reduction in the size of the federal government.

In the United Kingdom, Prime Minister Margaret Thatcher implemented similar policies, emphasizing tight monetary control, deregulation, and a shift away from state ownership of industries. Both Reagan’s and Thatcher’s policies were deeply influenced by the work of Friedman and other Chicago School economists, marking a dramatic shift away from the post-World War II Keynesian consensus towards a more market-oriented approach.

The influence of Monetarism and the Chicago School also extended beyond the English-speaking world. In Latin America and other parts of the developing world, the International Monetary Fund (IMF) and World Bank promoted policies that reflected Monetarist and Chicago School ideas, often in the form of austerity measures, privatization, and deregulation, particularly in the 1980s and 1990s.

Criticisms of Monetarism and the Chicago School

Despite their significant impact, Monetarism and the Chicago School have faced numerous criticisms over the years. Critics argue that the Monetarist focus on controlling the money supply is overly simplistic and fails to account for the complexities of modern economies. For example, during times of economic crises, such as the 2008 financial crisis, central banks have used unconventional monetary policies (such as quantitative easing) that challenge the traditional Monetarist view of fixed money supply growth.

The Chicago School has also faced criticism for its unwavering commitment to free markets, with detractors arguing that it overlooks the role of power imbalances and market failures, particularly in areas such as healthcare, education, and environmental protection.

Critics, including economists from the Keynesian and post-Keynesian traditions, contend that markets often fail to provide public goods and that government intervention is necessary to correct these failures. Moreover, the Chicago School’s approach to issues like income inequality and the role of the state in ensuring social welfare has been heavily criticized for prioritizing individual freedoms over collective well-being.

Lasting influence and legacy

Despite these criticisms, the ideas of Monetarism and the Chicago School continue to influence contemporary economic thought. The focus on monetary policy, inflation control, and the efficiency of markets remains central to many modern macroeconomic models.

In particular, the role of central banks in managing inflation and ensuring financial stability has been shaped by Monetarist ideas. The Chicago School’s broader influence on economics can also be seen in the widespread adoption of market-oriented policies across the world, from the deregulation of industries to the privatization of state-owned enterprises.

Furthermore, the Chicago School’s emphasis on individual choice and market solutions to social problems continues to resonate in debates around economic policy. The legacy of Monetarism and the Chicago School has endured through the decades, influencing policymakers and economists alike, and remains a vital part of the ongoing discourse on economic policy and theory.